A Model of Misconception

Sometimes when we learn the detail about something, we lose sight of the big picture. This problem is so common there are even clichés for it, like ‘...can’t see the forest for the trees...”

While this problem applies to all forms of trading, options trading theory is one of the most susceptible. The simple concept of wanting something you have bought to increase in value often gets lost in a beginner’s confusion about whether a long put or a short put is a bearish strategy.

I don’t want to imply that being a beginner is bad; we were all beginners at some point. My intension is to highlight the importance of always trying to understand things in their simplest terms first.

You would be amazed how many times I’ve heard someone suggest that the market has got a price wrong or that option is “misbehaving”. Anything can be over- or underpriced but the only way to vote on this is by trading (or not trading) it. There is no hotline to call and complain to Mr. Market that he should change the price. Money is made by the prices actually traded, not the prices that should have traded.

Which brings us to the crux of the issue - pricing models. Models are used in many aspects of life - mathematics, statistics, the economy, business, weather forecasting and even cognition (thought process). A model is an abstract designed to simplify and give us a better understand of what we are studying. The concept of ‘other things being equal’ is used to isolate variables and understand their impact, assuming nothing else changes.

Option Greeks can sometimes cause an option trader to lose touch with the basics. The Greeks are derived from option pricing models, like the Black & Scholes and Binomial. They are useful in identifying the risks of a given position, strategy or portfolio and for simulating the effects of different scenarios.

The problem is that the Greeks are sometimes incorrectly taught (or interpreted) as the drivers of an option’s price and as the factors that instigate price-changes.

In reality, the Greeks attempt to describe how an option is likely to perform given a change in the key factors that influence its price. If we use the weather as an analogy, the Greeks are best described as a forecast for the temperature tomorrow rather than a measure of today’s actual temperature. While this analogy isn’t perfect, it does highlight the main point – Greeks are a guide, not an absolute. They can be used to quite accurately break down and describe price changes but again, not perfectly. The real world is just too complex for any model. None will flawlessly describe reality all the time. A model that does this is not a model, it is reality. The point is that when the Greeks are slightly out in their explanation of what has occurred, this is completely fine and is, in fact, normal.

I’ve intentionally avoided mentioning any of the Greeks individually. The aim here is not to analyse how each of the Greeks work but to understand how they should and should not be used. They should be used as a powerful tool for ‘what-if’ scenarios and indentifying the bias and risk of a strategy or portfolio. They should not be used to forecast exact future movements.

With the increasing complexity of the financial world and so many different instruments and strategies to choose from, it is important to always boil things down to the simplest terms: things go up in price because demand - perceived or real - has increased and down in price because demand has decreased. Everything else isn’t superfluous, but is additional.